Performance appraisal evaluates whether investment results stem from skill or luck. It uses risk-adjusted performance measures to assess if a portfolio manager consistently adds value beyond their benchmark.
Key Performance Appraisal Metrics
- Sharpe Ratio
- Treynor Ratio
- Focuses on systematic risk by using beta as the denominator.
- Useful only for well-diversified portfolios without significant unsystematic risk.
- Information Ratio (IR)
- Measures portfolio performance relative to its benchmark, adjusted for tracking error.
- Higher IR indicates better risk-adjusted excess returns.
- Appraisal Ratio (AR)
- Alpha (excess return) divided by residual risk (standard deviation of unsystematic returns).
- Evaluates the effectiveness of active management.
- Sortino Ratio
- Similar to the Sharpe ratio but considers only downside risk (semi-standard deviation).
- Better suited for portfolios with non-normal return distributions or skewed risks.
- Example:
- Capture Ratios
- Upside Capture Ratio: Measures performance during positive benchmark returns:
- Downside Capture Ratio: Measures performance during negative benchmark returns:
- Capture Ratio:
- Example:
- Portfolio Upside Return: 5%, Benchmark Upside Return: 4% → Upside Capture: 125%125\%125%
- Portfolio Downside Return: −6%-6\%−6%, Benchmark Downside Return: −10%-10\%−10% → Downside Capture: 60%60\%60%
- Capture Ratio: 125%/60%=2.08125\% / 60\% = 2.08125%/60%=2.08 (positively convex return profile).
- Drawdown
- Measures the maximum decline from a portfolio’s peak to its trough before a new peak is achieved.
- Maximum Drawdown:
- Largest cumulative loss during a drawdown phase.
- Drawdown Duration:
- Time from the start of the drawdown to full recovery.
- Example:
Limitations of Appraisal Metrics
- Sharpe and Treynor Ratios:
- Penalize upside volatility equally with downside volatility.
- Treynor assumes well-diversified portfolios, making it unsuitable for concentrated strategies.
- Sortino Ratio:
- Requires a subjective choice of the Minimum Acceptable Return (MAR).
- Comparability may be limited between portfolios with different MARs.
- Information and Appraisal Ratios:
- Depend on the choice of benchmark; misspecified benchmarks can distort results.
- Capture Ratios:
- Do not account for absolute risk levels or portfolio volatility.
- Drawdown:
- Focuses only on past performance and ignores forward-looking risk measures.
- May overemphasize rare but extreme market events.
Key Takeaways
- Performance appraisal metrics help identify whether investment results stem from manager skill or market conditions.
- Each metric has specific strengths and limitations, making it essential to select the appropriate one based on the portfolio’s characteristics and investor objectives.
- Proper benchmark selection is critical to ensuring valid appraisals and meaningful insights.
